Income and wealth inequality is the root cause of financial instability. Capital, and the need for capital must be balanced for an economy to function stably.
If the accumulation of capital exceeds the need for capital to fund growth, the taxes on wealth and capital gains must be increased, and taxes on consumption and consumer income decreased .
If consumer demand, and the attendant need for capital, outpace capital accumulation, the reverse is required. Taxes then should be shifted from wealth and capital gains to consumption and consumer income.
Over the past several decades capital accumulation has outpaced the demand for capital, largely due to reductions in top bracket tax rates and stagnation of middle class incomes. The discussion that follows shows what happens when this occurs.
Enterprises need capital to expand and take advantage of new opportunities. This allows economies to grow to accommodate increases in population and the attendant need for new jobs.
If too little capital is accumulated, growth will be curtailed. If the effect is severe enough, sufficient growth will not be achieved to accommodate population increases and the need for additional jobs, and the standard of living will fall.
If too much capital is accumulated, rates of return on capital drop. As rates of return drop, capitalists seek ways to improve them through the use of leverage or the use of techniques to increase the demand for credit.
If leverage is used, risk increases, necessitating even larger rates of return. This leads to a potentially unstable situation. So there is a limit to the amount of leverage that can be used.
As the limits of leverage are reached, investment banks and hedge funds will look for ways to stimulate demand for credit. This can be done by relaxing the standards for issuing credit, and compensating by using techniques that hide risk.